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The increment in kerosene and diesel prices in Kuwait could lead to inflationary pressures18 - Jan - 2015

Kuwait Financial Centre “Markaz” published its report on the impact of rising fuel costs on the construction industry in Kuwait. In this report, Markaz analyzed the hidden cost to society with respect to abrupt large increases in fuel price levels. Though a revision of subsidies’ rationalization is understandable in terms of ensuring long-term fiscal sustainability, a strategic approach to implementation is called for with respect to roll back of subsidies in order to prevent inflation risk, which can have a negative effect that is unpredictable and potentially uncontrollable, as the effects pass through various industries and sectors, impacting investors’ sentiment in the process, as well.

The report stated that the fuel price increases may escalate costs facing the Kuwaiti construction industry to such an extent that it may amount to about 1% of GDP on the basis of even highly conservative estimates. Construction projects involve high levels of risk due to a combination of ‘one-off’ design and construction planning effort, fluctuating site-based working conditions that impact deadlines, dependence on fixed-price contracting and the broad fragmentation existing in the supply chains that support construction projects. In the context of value chain complexity that is connected to the construction industry’s highly fragmented supply chain structure, sudden movement in price levels in terms of key factors of input can have implications for viability of several projects, especially those financed by the private sector.

International evidence indicates that an increase in fuel cost by 30%-40% can hike the total cost of construction by about 2-5%. Thus, in the context of a threefold increase in the prices of kerosene and diesel in Kuwait, from 55 fils a liter to 170 fils (effective from January 1, 2015), the price of basic raw materials for construction and the transportation costs involved in servicing the construction industry will likely go up very high. With diesel constituting around a quarter of transportation energy consumption in Kuwait, a threefold increase in diesel prices will likely mean an increase in fuel costs for the construction sector by about 5%. In Kuwait, the construction industry, valued in standalone fashion, stands second to investments in the power sector. With such high investments running on the sector, inflationary pressures stemming from fuel price increases can increase project costs dramatically.

For Kuwait, the construction sector constitutes about 1.7% of the country’s GDP. Currently, there are a number of strategic infrastructure projects taking place in Kuwait, like the Kuwait Metro, Clean Fuels project, etc. The Kuwait construction industry is estimated to have drawn in approximately KD 4.9 billion worth of contracts by the end of 2014. However, the total cost of infrastructure and construction projects in Kuwait in 2014 is estimated to have touched ~KD 6.5 billion. This has increased the need for new technologies and innovative building materials, while attempting to find ways to keep other key cost components like fuel-connected ones low.

Between 2015 and 2020, an average annual investment spending of KD 11.8 billion is envisaged in Kuwait. Off this, about KD 6.3 billion per annum is budgeted for strategically important infrastructure projects, like the airport expansion project. Thus, the construction industry in Kuwait is expected to see a busy phase ahead. This implies that run away construction costs can hamper private involvement in the industry, particularly at a time when the government is pushing hard the PPP concept in infrastructure projects. With the government of Kuwait targeting a real private sector growth of 9.4% per annum on an average between 2015 through 2020, strategic infrastructure and construction projects are expected to receive more implementation attention given their critical role in supporting private sector growth.

Thus, there is a potential hidden opportunity cost on the Kuwaiti economy with the increase in prices of diesel, with respect to the additional costs imposed on the construction industry. In many countries around the world, the infrastructure sector is currently being looked upon to play a prominent role in reshaping the economy, reducing bottlenecks and in supporting the growth of the private sector. In such a scenario, the impact of sharp fuel price rises is that they will squeeze contractors’ margins. With respect to the GCC, the construction industry is already facing mounting costs of labour due to workforce shortages.

Typically, in the GCC, labour cost accounts for about 25% of the total cost, which in the face of workers’ shortage, will probably increase further. Thus, fuel price inflation can add greatly to the cost burden, making margins unprofitable for contractors’ and thus driving out private sector involvement in the construction industry in the process.

However, subsidies’ rationalization is important for long-term fiscal sustainability, though there might be short-term discomfort. The friction between long-term sustainability versus short-term financial pain can be alleviated to a significant extent by implementing fuel price increases in a gradual or phased manner. The key is to provide the time to adapt and to administer the inflationary impact in installments that are manageable over a long stretch of time; rather than a one-time large impact implementation.

An international case example where such a phased measure was adopted recently is India. In January 2013, the Indian government decided to deregulate diesel prices in a phased manner or stages, through 50 Indian paise a litre rise every month. By September 2014, the Indian government was able to remove the gap between the imported cost of the fuel and the retail selling price. In October 2014, the Indian government officially ended diesel subsidies completely. With longer strategic implementation schedules, opening channels for public debate and fostering transparency in studies, any resultant inflationary effects will get diluted across a protracted timeframe. Also, the implementation schedule must be communicated much in advance to stakeholders in society. Thus, the impact of prices increases can be greatly softened.

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About Kuwait Financial Centre “Markaz”
Kuwait Financial Centre K.P.S.C “Markaz”, established in 1974, is one of the leading asset management and investment banking institutions in the Arabian Gulf Region with total assets under management (AUM) of over KD 1.12 billion as of Sep 30th, 2014 (USD 3.89 billion). Markaz was listed on the Kuwait Stock Exchange (KSE) in 1997.